The UK stock market still looks cheap

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In my last column I argued that by many measures American shares are expensive. If that is the case, should you put your faith this year’s ISA money in UK plc?

Recently I presented Money Box Live on Radio 4 and interviewed the deputy governor of the Bank of England, Ben Broadbent. What really struck me were his thoughts on the long-term level of interest rates and how the interest rate needed to keep the economy stable had been coming down for decades, even more so since the financial crisis.

If we are in a new world order where interest rates never get above a few percentage points, then the UK stock market is cheap. But then that is a big ‘if’. Whether you are an overly optimistic bull or a growly grumpy bear largely depends on your view of interest rates in the long-term.

Let me explain. The two main investments are shares and bonds (the latter of which means investing in either corporate or government debt). Thanks to quantitative-easing (QE) and ultra-low interest rates, the UK government pays just 1.5 per cent interest a year to borrow for ten years. Prior to the crisis it was around 5-6 per cent p.a. That 1.5 per cent yearly interest payment does not even keep up with inflation at 3 per cent. By buying UK gilts, or leaving your money in bank savings, your money is steadily losing its purchasing power.

In contrast, the FTSE100 is paying a dividend yield of about 4 per cent, meaning you get 4 per cent of your initial investment back in dividends a year. You are getting almost three times the income by buying shares and receiving a 4 per cent dividend yield than if you bought government debt and received the 1.5 per cent interest coupon. That is why UK shares are cheap.

According to Russ Mould, investment director at AJ Bell, UK interest rates would need to rise substantially to make the UK stock market look expensive: ‘If history is any guide then bond yields are not a long-term threat to the stock market bull run.’

On top of this simple income comparison, bear in mind that share prices and dividends tend to increase as companies grow — two more ways to profit from buying shares.

Other measures also suggest the UK stock market is still good value. The P/E ratio (which is the ratio of the share price to the company’s profits, per share) is only around 14 times. This is about the historical average and not expensive. The US S&P500, for comparison, is trading at about 20 times forward earnings, and much more expensive.

And as Mr Mould notes: ‘The UK stock market has underperformed for two years and is under-loved, according to a Bank of America Merrill Lynch survey.’ And that means it could be time for catch up.

The global economy is growing at its fastest rate since the crisis and that is good news for the profits of the internationally focused companies in the FTSE100. And by investing in your home market, you are taking less currency risk, as you are buying shares in sterling.

So what are the risks? The major one is whether ‘the inflationary genie will pop out of the bottle’, as Mr Mould puts it. It was the whiff of wage inflation that contributed to the US stock market to sell off in early February. That’s because inflation will cause central banks to raise interest rates far more aggressively than expected. And as I have explained above, that hits the relative attractiveness of shares.

Falls in the stock market can also indicate economic weakness to come, which is the other risk of investing in UK plc. The UK economy has been in recovery for the past six years. At some point we are due a recession, which would be bad news for shares. But the Bank of England most recently increased its forecasts for UK GDP growth.

So the main question to ask before putting money into the UK stock market is whether we are permanently in a low inflation and low interest rate new world order. Or after excessive QE and ultra-low interest rates, are much higher inflation and interest rates just around the corner?

Most think the former. In which case the UK stock market is a good bet. But just because your cash is staycationing, it doesn’t mean you have to too. The good news for holidaymakers is that the pound is stronger, particularly against the dollar, than it was in the slump following the EU referendum.

This might be the year to book a foreign holiday to Miami but leave your money at home.